‘Fiscal Cliff’ Looms, but Investors Not Ready for It: BlackRock

The prospect of a "fiscal cliff, " a series of tax hikes and spending cuts that take effect early next year, could shave as much as $807 billion, or 5 percent, off U.S. economic growth, yet financial markets do not appear to be bracing for such a big risk event, fund manager BlackRock said in a report on Friday.

The inability of the Republicans and Democrats in the U.S. Congress to agree to a deal by the end of the year could have an enormous impact on the economy, experts say.

According to BlackRock, the world's biggest fund manager, investors are not priced for the possibility of a "fiscal cliff, " with most investors it speaks to believing "an 11th hour rescue" and monetary easing policies already in place will enable the U.S. to avoid a recession.

"The S&P 500 index is close to record highs and volatility is eerily low. Our conclusion: Markets have not priced in the 'fiscal cliff' and assume QE3 will drown out other factors, " it said, referring to a third round of quantitative easing by the Federal Reserve announced last month.

The "fiscal cliff, " a term coined by Fed chief Ben Bernanke, will trigger a significant recession and the loss of about 2 million jobs, the Congressional Budget Office said in August.

BlackRock is not the only voice expressing concern about U.S. fiscal policy.

Goldman Sachs CEO Lloyd Blankfein and other experts told CNBC on Thursday that the U.S. is heading towards fiscal disaster and that resolving the issue would go a long way towards restoring market confidence.

Indeed, such fears may increasingly weigh on investors, even if they are not worried right now, said Vasu Menon, head of wealth management at OCBC Bank in Singapore.

"In the last week, all of a sudden, the 'fiscal cliff' is talked about even more and it will gain more prominence as the U.S. presidential election approaches (next month), " Menon said. "I think some individual investors are complacent. They are not really thinking about it and they think policy makers will resolve it."

Clarity? Not Yet

Any policy clarity may only come in December, when the dust from the U.S. presidential election has settled, BlackRock said. The firm is preparing for three possible scenarios:

A "Sky Dive" would result if President Barack Obama wins a second term, because a deal between Democrats and Republicans is unlikely and this will put markets in "high anxiety."

A "Bungee Jump" scenario is likely if there is a victory by contender Mitt Romney and a Republican sweep of Congress. Initial "euphoria" will ensue as tax hikes would be reversed retroactively and the debt ceiling would be raised ahead of a full budget deal, according to BlackRock.

The final possibility is a "Hard Stop, " a screeching halt just before the cliff. This means that lawmakers would agree to some spending cuts and then hammer out a budget deal in 2013, the firm added.

"Market reception? Bliss … if there are enough signs and specifics to indicate a real budget deal is in the making, " BlackRock said.

But the fund manager added that investors have to guard against a sell-off in risk assets in the run-up to the possible "fiscal cliff, " such as U.S. equities, which have outperformed and become relatively expensive.

"If economic momentum weakens further, it is time to head for the U.S. departures lounge. Destination: emerging markets, " the firm said.—By CNBC's Jean Chua.